#TaxmannPPT | Mastering Price Adjustments & Earn-outs in Indian M&A | Khaitan & Co

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Mastering Price Adjustments & Earn-outs in Indian M&A Key Legal & Tax Insights

Thursday, 23 November 2023

Disclaimer Any information provided or any opinion given in this presentation does not constitute legal advice. Recipients must not rely or act upon such information or opinion and must take their own steps to obtain specific legal advice relevant to their own circumstances.

Opinions expressed in this presentation by individual partners or employees of Khaitan & Co (“Firm”) or unrelated parties are individual opinions and do not reflect the views of the Firm, and must not be attributed to the Firm, unless expressly confirmed in writing by the Firm.

The Firm accepts no responsibility or liability (whether by statute, in equity, in tort or otherwise) for any loss or damage (economic or otherwise) suffered by any person who relies or acts upon any information provided or opinion given in this presentation.

The law of India governs this presentation and all rights and remedies arising and recipients shall submit to the exclusive jurisdiction of the courts of India in respect of any claims arising out of or related to this presentation.

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About Us

Ranked as Tier I Indian Law Firm

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PRASENJIT CHAKRAVARTI

RITU SHAKTAWAT

Prasenjit is a partner in the corporate & M&A practice group of Khaitan & Co in the Delhi office. He has over 20 years of experience, specialises in advising domestic and international corporate clients on various business transactions, particularly in M&A and corporate matters. He has received several prestigious recognitions in the legal field, including recognised as India's Super 50 lawyers 2023 by ALB in 2023.

Ritu is a partner in the direct tax practice group of Khaitan & Co in the Mumbai office.

She has over fifteen years of experience. She focuses on transaction tax advisory, structuring and documenting M&A deals, and addressing intricate issues related to income characterisation, permanent establishment, India entry structures, EPC contract taxation, e-commerce business models, and funds taxation and documentation.

Contact:

Contact:

T: +91 11 4151 5454 | +91 99102 61530 E: prasenjit.chakravarti@khaitanco.com

T: +91 22 6636 5000 | +91 98191 08066 E: ritu.shaktawat@khaitanco.com

Best Overall Law firm 2023

Best Overall Law firm 2023

Ranked as Tier I Indian Law Firm

Law Firm of the Year

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India Tax Disputes Firm of the Year

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Agenda C Q&A

A Purchase Price Adjustments 1 What is it and why is it required?

2 Kinds of Purchase Price Adjustment

B Earn-outs

3 Regulatory issues

1 What is it and why is it required?

4 Potential drafting and negotiations issues

2 Structuring earn-outs

i Legal and Contractual issues 5 Tax considerations

3 Regulatory issues 4 Tax considerations 5 Potential drafting and negotiations issues i Legal, Regulatory and Contractual ii

Mechanics for measuring performance against earn-out targets

iii

Post completion operations of the target company

6 Determining a suitable structure Privileged & Confidential

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What is it?

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Reference Balance Sheet

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Signing Date

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Due Diligence and Negotiation

Adjustment Date

Preparation of Closing date accounts

Purchase Price Adjustment Pre-closing covenants / Standstill provisions

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Execution of LoI / Term Sheet

Fulfilment of Conditions Precedent – Regulatory approvals, third party consents etc.

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Closing Date

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Why is it required?

Buyer Perspective Preserve value and equitably allocate risks Protect against value erosion and value leakage until closing

Better protection than warranties and indemnities

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Fair allocation of risk.

Potential for upside if the cash or working capital position improves.

Seller Perspective

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Structuring Purchase Price Adjustments What could trigger such a fee?

Financial measures

Non-financial measures

 Cash: Estimated Cash minus Actual Cash

 Penalties for delay in closing

 Net working capital: Current assets (e.g., cash, accounts receivable and inventory) minus current liabilities (e.g., debt, trade creditors or accounts payable)

 Occurrence of a MAE event.

 Net assets: Total assets minus total liabilities  Net debt: Short and long-term debt minus cash and cash equivalents

Net Working capital adjustment is commonly used in M&A transactions

(included in 87% of deals from the 2021 ABA study) Privileged & Confidential

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Regulatory Issues 

Indian foreign exchange regulations liberalised  Amount: Upto 25% of the total consideration can be deferred  Time period: Upto 18 months from the date of the definitive agreement.

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Adjustment can be structured as holdback or through escrow

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The upfront amount paid as well as total consideration finally paid must comply with the pricing guidelines.

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Pricing guidelines are not applicable to FVCI investments.

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For public companies, SCRA requires that consideration should be paid simultaneously or within 1 day of transfer of shares.

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Drafting Issues – Legal and Contractual Financial metric should be defined.

Timelines and process of drawing up accounts should be pre-agreed

Dispute resolution process and engaging of experts to settle disputes.

Allocation of costs incurred

Set out the mode and manner of payment Any caps on adjustments Items which are expressly excluded from the scope of adjustments Privileged & Confidential

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Tax Considerations General principles  Timing: Taxable at the time of sale - “accrual” vs “receipt” debate  Characterization: Same as consideration, as capital gains

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upfront

Holdback / Escrow – Specific issues issues

 Entire consideration (including holdback) taxable upfront?  Whether any deductions from holdback escrow could potentially reduce the taxable consideration?

 Agreed terms / clauses are key

Other Considerations

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Tax deduction / collection at source: – in case of upward / downward adjustments to the consideration – interest on additional taxes to be deducted / collected in case of an upward adjustment

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Where purchase price adjustment spills over to another financial year – ability of seller to file a revised tax return or option of revision application to be explored

based on litigation outcome at a later date (eg after 2 years) – tax treatment and 03 Adjustments whether akin to indemnity Privileged & Confidential

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What is it?

Earn out  Contingent payment basis future performance and/or achievement of pre-defined milestones.  Earn out resolves differences between the parties on the expected growth and future performance of the target company.

Advantages of earn outs Buyer’s perspective

Seller’s perspective

 Mitigates risk of overvaluation  Deferment in payment obligation

 Potential to earn higher valuation  Benefit from economies of scale and increased investment

 Access to additional resources to discharge consideration

Basis of earn-outs Monetary thresholds

Non-monetary thresholds / milestones

 Increase in revenue, income, profit, sales or cash flows

 product development, governmental approval, number of employees, number of offices etc.

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Why use an earn-out?

The buyer and seller cannot agree on the value of the target company The seller may be more optimistic regarding the target company's prospects than the buyer.

Without an earn-out, the price the buyer is prepared to pay may be discounted as a result of doubt about the actual profitability or value of the target company. In this scenario, an earn-out can facilitate a more accurate valuation based in part on actual future performance, rather than past or predicted future performance.

Continued involvement of the seller is key

In some transactions, the continued involvement of certain sellers (such as founder shareholders) in the management of the target company after completion is important to secure the future success of the acquired business. In this scenario, an earn-out can be used as a mechanism to retain the relevant sellers and to incentivize them to maximize the target company’s profitability after the transaction has completed.

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Structuring Earn-out Commercials Vendors may transfer a proportion of their share holding to a purchaser on completion and enter into matching put / call options with the purchaser over the remainder of their shares, linking the exercise price of the options to future performance.

Earn out payments may be linked to turnover rather than profits.

Appropriate where the parties have adopted sales to value goodwill of the company.

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Sale of part

Payments Based on turnover

Service Agreement

All or nothing profit targets

Deferred payments linked to future performance under profit sharing clauses in service agreements, although such payments are likely to be treated as income receipts of the vendors.

All or nothing profit targets rather a profit multiplier.

Substantial risks for vendors in case the targets are not reached. Providing for the carry forward and carry back of profits over the target figures to other years in the earn-out period.

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Structuring Earn-out Commercials Question: What is better for the buyer? All-or-nothing or milestone based earn out?

Answer: Buyer would typically insist on all or nothing approach. Seller should insist on milestone based staggered payment structure.

Question: What is better for the seller? A short or a long time frame?

Answer:  Depends on the character of the business.  If growth spurt is expected, a shorter time frame may be best.  Generally, a balanced period of performance should be preferred.  Tip for buyer: If period is too short, seller may hurt long term interests of the target.

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Regulatory Issues

To elongate time period, earn outs can be structured as manager compensation or perquisite. The tax issues relating to this are discussed later.

In cross-border deals, earn out period available only for 18 months from signing 1

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The consideration paid upfront as well as finally paid must comply with the pricing guidelines 3

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Tax Considerations

Seller perspective  Contingent vs deferred payments  Contingent payments – taxable in year of transfer vs year of accrual • •

Contrary decisions of Bombay High Court and Delhi High Court Recent tribunal decisions – taxable at the time of accrual

 Characterization of deferred payment: •

Capital gains vs employment linked income

Buyer perspective  Withholding tax obligation • • •

On entire consideration (including deferred component) vs initial consideration Any interest exposure?

Contractual protections for any withholding tax claim

 Cost-basis •

Mode of allocation of deferred consideration in case of a slump sale

Practical issues •

Limited window to revise income tax return – 9 months from end of FY

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Post-completion operations of the target company Managed by Buyer

Managed by Seller

Undertaking by buyer not to make any material changes to the company's business

An undertaking by seller not to falsify the operations or the books of the target during the earn-out period.

Buyer to maintain separate books for the target company and to provide the seller with access to those books.

Buyer may want to seek "reverse" contractual protections to ensure that the earn-out is not distorted to its detriment.

An undertaking by buyer not to sell the target company or a material part of its business and assets during the earn-out period.

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Drafting issues – Legal and Contractual

DECISION MAKING POWERS

SCOPE OF BUSINESS FOR EARN OUTS

CALCULATION OF EARN OUTS

COST EXCLUSIONS

 Level of autonomy / rights of seller to operate the target business post-closing.

 Straightforward in case of a single business division.

 Typically, buyer since it is in control.

 Seller should exclude long term costs / expenses.

 Buyer should have levers / controls through reserved matters, board representation etc. to check seller actions.

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 Complex in case of multiple business divisions or merger of target’s business with buyer’s business.

 Seller should retain some degree of control and a right to review and dispute.

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Mechanics for measuring performance against earn-out targets Determining whether the earn-out targets have been satisfied

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Which financial statements will be used to measure the target company's performance?

Can the target company's statutory accounts for the relevant period be used, or will it be necessary to draw up special purpose accounts?

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For how long will the preparing party have to prepare and circulate its earn-out calculations to the other party?

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Applicable accounting framework adopted

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Seller Representative

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If there are several sellers, consider including a provision in the SPA appointing one seller as the sellers' agent with authority to exercise on their behalf all the sellers' rights concerning the review and agreement of the earn-out calculation.

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Drafting Issues  Easily identifiable metric  Performance metric should be straightforward with less chances of manipulation.  Revenue or EBITDA linked performance generally preferred.  Include a right-to-audit clause, providing full access to the accounts and set out the frequency of such procedures.

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Determining a suitable structure

To address tax and regulatory issues, delinking the earn-out component from the transfer of asset, could be explored - subject to commercial feasibility.

Option of structuring earn-outs as an employment linked payment or service fee could be explored – subject to ability to demonstrate “substance” in such arrangements.

Agreements to be carefully drafted to ensure intended tax outcome.

Valuation norms to be complied with in each case. Disproportionate or differential pricing structures to be supported by commercial rationale.

The transaction structure to be backed by commercial reasons and not driven primarily by tax reasons.

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Conclusion | Key Takeaways Risk Allocation

Risk allocation between the parties has always been the most significant aspect of any M&A deal. The sellers and buyers should accept purchase price adjustment and earn-out structure to bridge any valuation gap

Contractual Provisions

Watertight contractual provisions governing the mechanisms related to purchase price adjustment and earn-out structure should be included in the transaction documents to avoid issues at the time of implementation and ensure clear tax treatment.

Involving Experts

Expert legal and tax advice should be taken to ensure that the provisions meet the regulatory requirements as well as are carefully thought through to protect the interest of transacting parties.

Integration & customization

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Every contract has different specifications and circumstances. The extent and need of price adjustments and / or earnouts must be determined on a case–to-case basis.

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Q&A

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Contacts

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Prasenjit Chakravarti

Ritu Shaktawat

Partner Corporate & M&A prasenjit.chakravarti@khaitanco.com

Partner Direct Tax ritu.shaktawat@khaitanco.com

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